Muni market pondering the future of refinancing

Municipal market professionals remain committed to bringing back tax-exempt advance refunding while they explore other avenues to replace the refinancing savings once offered by that tool, even as worry mounts that interest in reviving it may begin to wane both in Congress and among younger municipal market participants.

Since the elimination of tax-exempt advance refunding by the 2017 Tax Cuts and Jobs Act, the muni market has adapted with a number of alternative structures designed to replicate the benefit of such deals as much as possible. But while some reliable options have emerged, market professionals remain hopeful the old advance refunding will return before the desire to bring it back loses any momentum.

“The two most common that I have seen are taxable advance refundings and forward delivery tax-exempt refundings,” said Rich Moore, a tax partner at Orrick, Herrington & Sutcliffe, describing avenues to “replace” advance refunding.

“Neither is as good for the issuer/borrower as a tax-exempt advance refunding. For taxable advance refundings, the interest cost on the refunding bonds is simply higher than in a tax-exempt refunding.  In a forward delivery tax-exempt refunding, there is a premium tacked on to the interest rate on the refunding bonds.”

Forward delivery bonds are paper priced on a determined date but which aren’t issued and settled until a future date. Their popularity began to rise after the 2017 legislation was enacted and hit a record issuance amount in 2021.  

Advance refunding allowed states and localities to refinance existing debt by issuing tax-exempt bonds, which represented about 20% of bond activity in 2017. 

Possible solutions to its demise also include tender offers where issuers can restructure debt by offering bond holders the option of tendering their bonds for cash or exchange them for new bonds at a specified date and price. The tendered bonds are then purchased by the issuer and canceled or exchanged for new bonds.

“The use of tenders to create a current refunding is one option that has seen some good successes, especially in situations where the tax codes allow for issuance of tax-exempt bonds to refund recently issued taxable advance refunding bonds,” said David Erdman, a managing director at Baker Tilly.

Tender offers are subject to a full slate of IRS regulations but still caught fire in 2020 with volume rising above $4 billion in 2021 and 2022. As of July this year, Bloomberg reported that about $14.1 billion had been tendered or invited to tender for this year. The amount includes $9.3 billion as taxable with $4.8 billion tax-exempt.

Erdman also points to the option offered by swap-related products with a caution. “Issuers and advisors will need to remind themselves of the analysis and risk assessments needed for such options,” he said. 

Despite the alternatives, the muni lobbying community is keeping hope alive about restoring the valuable money-saving tool.

“None of these workarounds fully replace the flexibility and options offered to issuers by advance refunding bonds, and none of them work in every situation,” said Brian Egan, director of government affairs at the National Association of Bond Lawyers. 

Assuming that Congress could bring advance refunding back from the grave questions remain about whether it would return in a recognizable form.

“The old rules had a lot of room for improvement,” said Johnny Hutchinson, a partner at Nixon Peabody. “They were overly and sometimes almost arbitrarily harsh.” 

Hutchinson also believes that trying to get Congress to fiddle with the rules might make things worse. “This is why most if not all of the legislation proposed since the passage of the TCJA that would bring back tax-exempt advance refundings has taken the ‘put it back’ approach,” he said.  

The current elevated level of interest rates renders the major selling point of  advance refunding moot, while also opening up other possibilities.

“In the interest rate environment in the final decade of advance refundings, there was typically negative arbitrage in the escrow that would have to be a negative factor in evaluating debt service saving,” said Moore. “In the current interest rate environment, there would not be negative arbitrage to cut into the savings amounts.” 

Since the rules changed in 2017 a new generation of muni practitioners have come of age with no knowledge of the tool. The possibility of the industry and the legislature losing interest is already a cause for concern.

“Unfortunately, that will occur, especially with state and local budget positions and the amount of federal funds currently provided for infrastructure via the IIJA and IRA,” said Erdman. “It will be those future budget pressures that will remind issuers of the costs and lost benefits from the elimination of tax-exempt advance refunding transactions.”